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Real Estate Investing Showing Its Risks

For the past 20 years, Canadian real estate has been poster child of the perfect investment. Even during the Great Financial Crisis of 2008, the real estate market in Canada did not blink an eye. 2008 was a speed bump. Real estate investing is impenetrable and there is nothing you can’t do with it that won’t make it profitable. Whether it’s renovating and flipping, doing short term rental through AirBnb or just selling units on assignment, there was no risk. That was true until an invisible enemy named Covid 19 threw a wrench in the party. Now those investing in real estate are starting to see the true risks.

Social Distancing Hurting Real Estate Sales

Let’s start out with the fact that everyone is required to practice social distancing. This is making it hard for the real estate industry because buying and selling real estate requires homes to be open to strangers. Furthermore, real estate agents build relationships through multiple meetings with clients. They need to understand the needs of the buyer or seller and this requires close interaction. This is completely the opposite of social distancing.

Though technology exists to overcome such hurdles, such as virtual tours and Zoom meetings, this does not translate well. Home buying is an emotional experience. A virtual tour doesn’t provide the same emotional impact as seeing it in real life. Our endorphins don’t react to digital images of a quartz counter-top as it does when our fingertips hit the surface. On top of that how many people do you know who have bought their “forever home” looking at virtual tour? Probably none.

Investors Experiencing Cash Flow Issues

Perhaps the greatest risk in investing in real estate is finally starting to show its ugly head. During the best of times, owners in real estate have very little trouble paying their mortgages. Either their tenant paid the mortgage or subsidized a large portion. Covid 19 changed all of that.

At the end of March, the “Keep Your Rent” movement started up that probably had landlords crapping their pants. Without rent coming in, landlords would be on the hook for mortgage payments out of their own pocket. This led to an outcry by homeowners and landlords to have their mortgage payments deferred so that their homes don’t go into default.

Though a large number of people paid rent for April, the full effect of having to shut down the economy won’t be felt until May. How will individuals pay for rent in major cities like Vancouver and Toronto when average rent exceeds the $2000 CERB handout?

Don’t Pay Your Mortgage

With so many Canadians losing their jobs at the beginning of the Covid lock down, the government had to make a plea to the big banks to allow homeowners to defer their mortgage payments. The response was “tremendous” as President Trump would like to say. At the large banks, almost 600,000 applications for mortgage deferrals were received. On a recent survey, one in twenty (that’s 5% of mortgage holders) missed their mortgage payments. 75% of the people who already missed a payment expect to miss another one.

Remember that many Canadians rely on rental income to help pay for the their mortgages. This can’t be more true than in expensive cities like Toronto and Vancouver, where rental suites are a hot thing. Without tenants paying half the mortgage, where is the money going to come from?

This equates to what this blog has mentioned before. Cash flow can be more important than owning your own home. Many homeowners overstretched and indebted themselves with mortgages that were far too big to carry. Where was the emergency fund that everyone should be saving for? Had we all forgotten about that?

The Only Investment That Requires More Cash

What makes real estate investing different and increases risk, is the fact that it requires additional monthly cash to keep it going. This is different than owning stocks or having a GIC in the bank because those investments can be bought and held without any additional capital.

Real estate investing is different. Property owners have extra expenses on a month to month basis that reduces cash flow. Though rent is collected, that money needs to be used to pay off a mortgage, property taxes and insurance. These are extra expenses that reduce cash flow.

This extra cash flow requirement increases risk. You can have a property that is worth hundreds of thousands or even millions, but the inability to pay off the monthly expenses can be devastating. It’s true that stocks can go down in value, and very fast too, but it does not drain monthly cash flow. Real estate investing can be extremely risky. Lack of cash flow can lead to insolvency.

Millionaire To Bankruptcy

A lot of people wonder how someone can be a multi-millionaire one day and then be bankrupt the next. That’s easy! No cash flow. It’s the same reason why a multi-national corporation can be making billions of dollars one year and then the next year file for bankruptcy protection. It’s the lack of cash flow.

You can own a lot of assets, in this case investment real estate, but once the cash stops coming in. It’s a big problem. Many investors don’t buy their investment properties with cash. Despite the myth that Chinese multi-nationals own all the condos in Toronto, many of the properties are snatched up by amateur landlords by normal Canadians. Three years ago, almost 15% of GTA residents owned investment property, no doubt this percentage has increased over the last few years with the popularity of real estate investing.

Popular Toronto Life blog covers many such Canadians. Like this real estate agent with 3 properties, or this teacher with $3.2M in properties, or even this individual with 10 investment properties. None of which are Chinese internationals. Many of these individuals use leverage. The use of leverage is great when the market is stable, but in times like today, the lack of cash flow can make real estate investing extremely risky.

Imagine owning 10 investment properties with mortgages and 3 tenants stop paying. How do you pay the mortgage on those 3 properties? That could be $6,000 owed each month. The longer this Covid lock down lasts, the much greater the risk. What happens if two more tenants lose their jobs in this recession. How do you cover 5 mortgages that could be $10,000 a month?

This is how bankruptcy happens. The accumulation of debt and the lack of cash flow to cover the payments. When investors cannot cover their monthly costs they can go into bankruptcy. That’s when creditors start liquidating assets to cover debts. It’s true that the properties still have value, but that value can only be extracted through selling the property. This is where another risk to real estate investing can show up. The lack of liquidity.

Real Estate Investing Has Liquidity Risk

We can see what happens when investments start to do poorly. People start to sell it like crazy. There’s no better example of mass selling than the stock market. The stock market is extremely easy to get your money out. Just a few clicks on the Internet and you can turn your investments into cash.

The ease of converting real estate to cash is not quite as easy. It requires someone to view it, inspect it, like it and then put an offer down. Even when a property sells it can still takes weeks or even months for the buyer to secure financing and take possession. During a pandemic lockdown, as we are having now, this is making it much harder for people to access their wealth.

The Covid 19 virus has exacerbated the liquidity risk that real estate poses. In good times a house might sell in a week and possession might be taken within a month. That is still 30 days to convert a property to cash. In times like this where sales of homes are down 69% in the Toronto area, the hottest market in Canada, converting the investment property to cash could take over 3 months. Let’s not even talk about how long it might take for people to be comfortable with hiring movers to move their belongings to a new house.

Supply Glut On The Horizon

Vancouver skyline

Real estate prices can rise unabated when there is excess demand and not enough supply. But the current Covid 19 crisis is having an adverse effect. One of the largest reasons for the lack of supply in major Canadian cities was this rise in popularity of the home sharing platform Airbnb.

Real estate investors could buy a condo, and easily rent it out for a few days of the month to recouperate mortgage costs without having to worry about long term tenants. Now with Covid 19 wrecking havoc on the travel industry, it could take years before travel demand returns.

Also with the increased restrictions for workplaces, businesses are finding out first hand just how effective their work force can be working from home and whether this could become a more permanent way in which employees work.

This all leads to fear from real estate investors who thought their condo investments were completely risk free. A recent Vice article shows that thousands of condo units in Toronto were listed on Airbnb. These owners are now facing a very tough situation. With no travelers booking these rooms for the foreseeable future, how will the mortgages get paid?

Flooding the market with thousands of condo units will have a huge price impact. Given that demand is already low, and supply has the potential to explode, what will happen to the value of these condo units? If many of these units are converted to long term rentals, this will have an adverse affect on rental rates in large cities. Though it might sound good for tenants, this will have an impact on landlords who rely on high rents to cover high mortgage payments. What happens when rent doesn’t cover the mortgage? This is the same cash flow dilemma that I mention above. It’s a quick way to become insolvent.

REITs Are Not Immune

I wrote before how REITs could replace investment properties for those who do not have enough cash to afford a down payment on a property. However, buying REITs for real estate investing is not without risk. Just like real estate investing, REITs carry the exact same risks.

ZRE REIT ETF stock chart

Over the last month many retail shops and offices have been closed due to Covid 19 restrictions. This has led to a monumental fall in the share prices of many REITs. Why, you might ask? It’s simple. Just like residential landlords, REITs are finding that many of their tenants are not paying rent. Yep, that’s right. It’s not just Joe Average that cannot afford their rent, but large scale retailers are not paying their rent either.

The owner, Oxford Properties, of popular malls like Yorkdale and Square One in GTA, have reported that only 20% of stores have paid their rent. This is a massive decrease in revenue for these property management companies. Once thought of as can’t lose investments, real estate properties are bleeding cash. The cost of operating a large mall with no tenants paying rent is just unfathomable!

Investors that buy REITs are suffering the same fate as investment property owners only they are feeling the impact much more immediate with drops in the share price. REITs like Rio Can and SmartCentres that run many strip malls in Canada are suffering large losses as tenants don’t pay rent.

No one knows when businesses can reopen which creates even greater risk. Just like individuals with mortgages, REITs also have mortgages to pay too. When rent stops coming in the same risks apply to REITs as they do individuals.

Real Estate Investing Not Immune To Risks

Real estate investing has always been though of as being a risk free endeavour, but investors are now finding out first hand that the risks are there. The Covid lock down has only been in effect for one month. The longer it lasts, the greater effect these risks will have on landlords.

For the time being, real estate values have still held their own. The risks haven’t had any impact on pricing due to drastic measures put forward. Banks have allowed property owners to defer their mortgages which eliminates the cash flow issue for 3-6 months. The Canadian government has provided rent subsidies to small businesses to keep rent flowing to landlords. But these measures cannot last forever.

How the economy rebounds from the Covid lock down will prove to be the answer to whether real estate investors will suffer losses or continue their ascent to the heavens. If unemployment stays high and consumer confidence fails to return, the risks mentioned above will become much more pronounced.

 

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